Sorting Out Dodd-Frank’s Treatment of Failed Broker-Dealers

By Stephen J. Lubben

Feb. 25, 2016

All the relevant financial regulators recently got together and released proposed rules regarding the treatment of failed broker-dealers under Dodd-Frank’s Title II (also known as “orderly liquidation authority”). The proposed rules are long, and there was little attention.

But there was one interesting bit: namely, the assertion in the proposed rules that when Dodd-Frank says there is to be “an application for a protective decree under the Securities Investor Protection Act of 1970 as to the covered broker or dealer,” it does not actually mean there would be a case filed under the Securities Investor Protection Act.

That is not the way I understood the statute. And I suspect it was not the way most lawyers — outside the regulators, at least — understood the statute.

Dodd-Frank’s treatment of failed broker-dealers has always been a bit confusing. In short, the law seems to contemplate that an orderly liquidation authority proceeding will be commenced against the broker-dealer and that the Federal Deposit Insurance Corporation will take control over a large part of the operation by moving assets into a “bridge bank,” although perhaps here we should call it a “bridge broker-dealer.” This is a newly created company — unlike most broker-dealers it can be given a federal charter — that will keep operating the broker-dealer for at least an interim period.

The orderly liquidation authority also mandates that the Securities Investor Protection Corporation be appointed trustee of whatever is left, and that the application “for a protective decree” cited in the rules is to be filed with a federal court under the Securities Investor Protection Act.

I read this to mean that the S.I.P.C. would conduct a traditional liquidation under the act of the “stub” of the failed broker-dealer. Whatever assets remained would be administered for the benefit of creditors, which would potentially include bondholders and customers whose claims exceeded the protection provided by S.I.P.C.’s insurance system.

And the language in Dodd-Frank that I quoted above sure sounds like the same language in the statute that explains how the Securities Investor Protection Corporation normally commences a case. But instead, the regulators are asserting that “in reality there is no proceeding under S.I.P.A. and the covered broker-dealer is being liquidated under Title II.”

What difference does it make? Practically, it may not amount to much, since the piece of the broker-dealer that the S.I.P.C. is left with will likely be limited, whatever law it is operating under. In most cases, customers will not notice a difference unless they have a claim for “lost” property in their accounts beyond the insurance coverage.

But the important area where it might matter would involve noncustomer creditors of the broker-dealer, or customers asserting such a shortfall. Here it might matter that a S.I.P.C.-overseen liquidation under orderly liquidation authority would presumably not be conducted before a bankruptcy judge. Thus, the process would be more like the F.D.I.C. part of the process, and less like a traditional S.I.P.A. broker-dealer proceeding.

From the regulators’ perspective, that might be a good thing. No pesky courts, with their painfully slow “due process” considerations to worry about.

But from the market’s perspective, I wonder if this does not make orderly liquidation authority even more of a “black box” than it already was.